Growth Gain Versus Fiscal Pain: The Economic Impact Of Corporate Tax Rate Cuts

The Indian government on Friday announced its most decisive step yet in combating a five-quarter slowdown, which has taken the country’s gross domestic product growth rate down from 8 percent to a six-year low of 5 percent.

After initially relying on monetary policy and improved credit flow as ways to push up GDP growth, the government appears to have finally come around to the view that a fiscal push was essential to boost growth and sentiment.

Ceteris Paribus, the revenue loss of Rs 1.45 lakh crore estimated by the government will push up the fiscal deficit to near about 4 percent. However, should there be some spending cuts or additional revenue generated through asset sales, the impact on the fiscal deficit could be lower.

Growth Gains: Banking On Trickle Down

What the government is attempting is fiscal pump-priming of the economy, undertaken last in India after the global financial crisis. The difference, though, is that the current government has chosen the route of corporate tax rate cuts, in the hope of encouraging investments. In contrast, the 2008-09 fiscal package was aimed at increasing spending and boosting consumption.

As such, any benefits of the corporate tax rate cuts to the economy will flow through corporations rather than directly to consumers.

According to data provided by the government, the effective tax rate for companies with a turnover of more than Rs 400 crore shall be 25.17 percent (inclusive of surcharge and cess) versus 34.9 percent earlier. These tax savings, if they materialise, will translate into higher profitability for corporations with varying magnitudes.

According to Morgan Stanley, the tax cuts will help boost corporate savings and could eventually boost their ability to invest. But there is an ‘if’ here. Private investments will pick-up if demand stabilises and capacity utilisation improves from the current levels of about 75 percent.

According to UBS, the stronger profitability may allow companies to be more liberal in cutting product prices in response to weak demand. And this, in turn, may help boost consumption. Again, that is ‘if’ companies chose to cut prices.

Of course, corporations could just choose to step up dividends, in which case only a finite set of shareholders will benefit from the tax cuts.

But there may be other intangible benefits. Sentiment has been a meaningful part of the deterioration in the Indian economy in the last 3-6 months. Some boost to business sentiment and to investor sentiment may help counter the negative feedback loop that often results from a mood of gloom and doom.

Overall, Barclays sees a 0.5-1.0 percent boost in nominal growth, and 0.3-0.8 percent in real growth, depending on the cascading impact on investment and consumption.

Fiscal Pain: It’s Here And It’s Now

While the timing and extent of the growth impact is difficult to judge, the fiscal math is much easier to do.

The Rs 1.45 lakh crore revenue loss assumption the government has put out works out to about 0.7 percent of GDP. In one shot, the fiscal deficit moves up to 4 percent. It takes us back to FY15 when we were running a fiscal deficit of 4.1 percent.

Should the government attempt to counter this through spending cuts, it will only hurt the economy and take away any growth benefits this fiscal push may yield. A better way to make up for the shortfall would be through asset sales. Unless there are some big ticket asset sales, a material widening of the fiscal deficit this year seems inevitable.

This wider fiscal deficit will mean higher government borrowings in a market which is already crowded and struggling to absorb debt issuances by government and government linked firms. According to Sajjid Chinoy of JPMorgan, total public sector borrowings have been running at 8.5-9 percent of GDP, absorbing much of the financial savings from the market.

This fear played out in the bond markets on Friday as bond yields jumped over 15 basis points to 6.8 percent. With this jump, the spread over the benchmark repo rate, known as the term premia, has widened back to nearly 150 basis points. Higher term premia and the prevailing risk-aversion on corporate credit will mean that borrowing costs for corporations will actually rise even though policy rates have been cut by a 110 basis points since the start of this year.

The wider fiscal deficit will also complicate decision making for the Monetary Policy Committee. Since inflation is well below the 4 percent mid-point of the MPC’s target, the government’s announcement may not hurt the immediate expectations of another 25 basis point rate cut in October but it may prompt the committee to evaluate the extent of cuts needed beyond that.

Where Does The Balance Lie?

For now, its seems like the macroeconomic balance of Friday’s announcements is titled towards the immediate fiscal risks the decisions pose.

S&P Global Ratings termed the development as ‘credit negative’ for India.

“India’s surprise corporate tax rate cuts are likely to boost sentiment and support the broader economy at a time when momentum is flagging. These effects may marginally offset the direct negative impact to the government’s fiscal position,” the rating agency said.

S&P expects deficits to widen and given the already high general government fiscal deficits, it sees this as a credit negative development, it said in a note.

In the long run, though, should this move help spur growth via a pick-up in investments rather than consumption, it will yield a larger dividend for an economy which has been struggling to take its investment rate back up to the highs of the pre-global financial crisis period.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.